Government Intervention: Indirect Taxes & Subsidies (DP IB Economics)

Revision Note

Last updated

20 September 2024

Indirect Taxes

An indirect tax is paid on the consumption of goods/services
- It is only paid if consumers make a purchase
- It is usually levied by the government on demerit goods to reduce the quantity demanded (QD) and/or to raise government revenue
- Government revenue is used to fund government provision of goods/services e.g education
Indirect taxes are levied by the government on producers. This is why the supply curve shifts
An indirect tax can be either ad valorem or specific

1. A Specific Tax

A specific tax is a fixed tax per unit of output (specific amount) e.g. $3.25/packet of cigarettes

The impact of an indirect tax is split between the consumer (A) and the producer (B)

Diagram Analysis

Initial equilibrium is at P₁Q₁
The government places a specific tax on a demerit good
- The supply curve shifts left from S₁→S₂ by the amount of the tax
The price the consumer pays has increased from P1 before the tax, to P2 after the tax
The price the producer receives has decreased from P1 before the tax to P3 after the tax
The government receives tax revenue = (P₂-P₃) x Q₂
Producers and consumers each pay a share (incidence) of the tax
- The consumer incidence (share) of the tax is equal to area A: (P₂-P₁) x Q₂
- The producer incidence (share) of the tax is equal to area B: (P₁-P₃) x Q₂
New equilibrium is at P₂Q₂
- Final price is higher (P₂) and QD is lower (Q₂)
- If the decrease in QD is significant enough, it may force producers to lay off some workers

2. Ad Valorem Tax

A tax that is a percentage of the purchase price e.g. Value added tax (VAT) in Columbia in 2022 was 19%
- The more goods/services consumed, the larger the tax bill
- This causes the second supply curve to diverge from the original supply curve
- VAT raises significant government revenue

1-4-1-government-intervention---ad-valorem-tax

A diagram showing an ad valorem tax (VAT) and the tax incidence for producers and consumers

Diagram Analysis

Initial equilibrium is at P₁Q₁
The government places an ad valorem tax to raise government revenue
- Supply shifts left due to the tax from S → S + tax
  - The two supply curves diverge as a percentage tax means more tax is paid at higher prices
The price the consumer pays has increased from P₁ before the tax, to P₂ after the tax
The price the producer receives has decreased from P₁ before the tax to P₃ after the tax
The government receives tax revenue = (P₂-P₃) x Q₂
Producers and consumers each pay a share (incidence) of the tax
- The consumer incidence (share) of the tax is equal to area A: (P₂-P₁) x Q₂
- The producer incidence (share) of the tax is equal to area B: (P₁-P₃) x Q₂
New equilibrium is at P₂Q₂
- Final price of goods/service is higher (P₂) and QD is lower (Q₂)
- If the decrease in QD is significant enough, it may force producers to lay off some workers

Examiner Tip

When drawing this diagram, students often find it hard to identify the three price points.

The tax incidence boxes are formed by drawing the new equilibrium quantity through the original supply curve. The three price points are the old equilibrium point, the new equilibrium point - and where the new quantity crosses the original supply curve.

Irrespective if you are dealing with taxes or subsidies, always use the new equilibrium point to determine your incidence boxes.

The consumer incidence is paid from the consumer surplus area and the producer incidence is paid from the producer surplus area.

Worked Example

Refer to the graph below and answer the questions that follow.

ibdp-economics-calculating-taxes-from-a-diagram

Answers:

a) The Government imposes a tax of £20 on a product. Calculate the tax revenue collected by the government [2]

The per unit tax = £20
The quantity traded with the tax is 60,000 units
The total tax revenue gained by the government = £20 x 60,000 units (1 mark)
= £1,200,000 (2 marks for the correct answer)

b) Calculate the incidence of tax paid by the producer [2]

Consumers used to pay £30 for the product
They pay £40 with the tax - £10 extra
The tax incidence for consumers = £10 x 60,000 units (1 mark)
= £600,000 (2 marks for the correct answer)

c) Calculate the change in consumer spending after the imposition of the tax [2]

Before the tax, consumers paid £30 for the product and 80,000 units sold
- Consumer Expenditure = £2,400,000
After the tax, consumers paid £40 for the product and 60,000 units sold
- Consumer expenditure = £2,400,000
There is no change in consumer expenditure (1 mark + 1 mark for any correct working)

d) Calculate the deadweight loss caused by the imposition of the tax [2]

The deadweight loss is the loss of consumer and producer surplus
It is equivalent to the area of the triangle that forms between the new equilibrium quantity and the old equilibrium quantity

$= \frac{b \times h}{2} = \frac{80 000 - 60 000 \times 40 - 20}{2}$ (1 mark)

$= \frac{20 000 \times 20}{2} = £ 200 000$ (1 mark)

e) Calculate the producer surplus after the imposition of the tax [2]

Producer surplus is the area above the supply curve but under the price producer receive
Producers receive £20 as the government receives the balance of the purchase price of £40 which represents the tax
The producer surplus can be calculated by using the formula to calculate the area of a trapezium

$= \frac{a + b}{2} \times h = \frac{20 000 + 60 000}{2} \times 20$ (1 mark)

$= £ 800 000$ (1 mark)

An Evaluation of Indirect Taxes

The Advantages and Disadvantages of Indirect Taxes

Advantages	Disadvantages
Raises the price and reduces the quantity demanded of demerit goods Reduces external costs of consumption and production Raises revenue for government programs	The effectiveness of the tax in reducing the use of demerit goods depends on the price elasticity of demand (PED) Many consumers who purchase products that are price inelastic in demand will continue to do so It may help create illegal markets as consumers seek to avoid paying the taxes Producers may be forced to lay off some workers as output falls due to the higher prices

A side by side Comparison of the Impact of PED on Tax Incidence

Aiming to maximise their profits, producers pass on as much of the indirect tax as they can to consumers and pay the balance themselves
The amount passed on to consumers depends on the price elasticity of demand (PED) of the product

1-2-9-ped-side-by-side-comparison_edexcel-al-economics

A diagram that demonstrates the tax incidence for a product whose PED is inelastic (left) and elastic (right). A is the consumer incidence and B is the producer incidence

Diagram Analysis

In both diagrams
- The specific tax shifts the supply curve from S₁→S₂
- There is a higher market price at P₂ and lower QD at Q₂
- Tax revenue for the government is the sum of A+B
- Consumer incidence is represented by A and producer incidence by B
- Total revenue for the seller is calculated using P₃ X Q₂
- The difference in PED results in a different steepness to the demand curve
For an inelastic product (e.g. cigarettes)
- The curve is steep
- Producers pass on a much higher proportion of the tax to consumers (A) and pay the rest themselves (B)
- The QD decreases (Q₁→Q₂) but by a much smaller proportion than the increase in price (P₁→P₂)
For an elastic product (e.g. pizza)
- The curve is much flatter
- Producers pass on a much smaller proportion of the tax to consumers (A) and pay the rest themselves (B)
- The QD decreases (Q₁→Q₂) but by a much larger proportion than the increase in price (P₁→P₂)

Examiner Tip

When asked to evaluate the impact of a tax in a particular market, it is essential to apply knowledge of PED to the impact it will have on producers, consumers and the government.

It should be obvious from the context if the product in question is elastic or inelastic in demand. If not, work through the factors that determine PED and make a judgement as to whether the product is elastic or inelastic in demand. In your answer, explain your reasoning.

Subsidies

A producer subsidy is a per unit amount of money given to a firm by the government
- To increase production
- To increase the provision of a merit good
The way a subsidy is shared between producers and consumers is determined by the price elasticity of demand (PED) of the product
- Producers keep some of the subsidy and pass the rest on to the consumers in the form of lower prices

A diagram which demonstrates the cost of a subsidy to the government (A+B) and the share received by the consumer (A) and producer (B)

Diagram Analysis

The original equilibrium is at P₁Q₁
The subsidy shifts the supply curve from S → S + subsidy
- This increases the QD in the market from Q₁→Q₂
- The new market equilibrium is P₂Q₂
- This is a lower price and higher QD in the market

Producers receive P₂ from the consumer PLUS the subsidy per unit from the government
- Producer revenue is therefore P₃x Q₂
- Producer share of the subsidy is marked B in the diagram
The subsidy decreases the price that consumers pay from P₁→ P₂
- Consumer share of the subsidy is marked A in the diagram
The total cost to the government of the subsidy is (P₃- P₂) x Q₂ represented by area A+B

Examiner Tip

Memorise the distinction below as students get very confused when answering questions on subsidies.

When dealing with a subsidy, the producer benefit is now the top portion of the incidence area and consumer incidence is below. This can be confusing as in all other diagrams, it is the other way around (surplus, indirect tax etc.)

Logically, it makes sense. Producers are given an extra amount of money for each unit by the government so this raises the sales revenue they receive, while at the same time lowering the price consumers pay.

Worked Example

The table below contains the demand and supply schedule for the electric vehicle market in Luxembourg (prior to any subsidies)

Price (€ 000s)	Qd (000s)	Qs (000's)
10	800	200
20	700	300
30	600	400
40	500	500
50	400	600
60	300	700
70	200	800
80	100	900

Answers:

a) The government introduces a subsidy of €10,000 per vehicle. Draw the supply and demand graph together with the new curve which includes the subsidy [3]

ibdp-economics---calculating-subsidies-from-a-diagram

(1 mark for accurate labels; 1 mark for correctly drawn demand and supply curve; 1 mark for correct shift of supply curve)

b) Calculate the total cost to the government of providing the subsidy [2]

550,000 EVs sell with the subsidy (1 mark)
Each EV is subsided at €10,000
The total cost to the government is €10,000 x 550,000 = €5,500,000,000 (1 mark)

An Evaluation of Subsidies

The Advantages and Disadvantages of Producer Subsidies

Advantages

Disadvantages

Can be targeted to helping specific domestic industries
Lowers prices and increases demand for merit goods
Helps to change destructive consumer behaviour over a longer period of time e.g. subsidising electric cars makes them affordable and helps motorists to see them as an option for the masses, not just the wealthy
Can be used to help domestic firms compete internationally

Distorts the allocation of resources in markets e.g. it often results in excess supply when used in agricultural markets
There is an opportunity cost associated with the government expenditure - could the money have been better used elsewhere?
Subsidies are prone to political pressure and lobbying by powerful business interests e.g. most oil companies receive subsidies from their respective governments (despite making $billions in profits each year)
Subsidies can disincetivise firms from becoming more efficient or competitive. They provide extra funds which reduce the need to be more competitive

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